The exact nature and cause of supply shocks is imperfectly understood. The most common explanation is that an unexpected event causes a dramatic change in future output. According to contemporary economic theory, a supply shock creates a material shift in the aggregate supply curve and forces prices to scramble towards a new equilibrium level.
The impact of a supply shock is unique to each specific event, although consumers are typically the most affected. Not all supply shocks are negative; shocks that lead to a boom in supply cause prices to drop and raise the overall standard of living. A positive supply shock may be created by a new manufacturing technique, such as when the assembly line was introduced to car manufacturing by Henry Ford. They can also result from a technological advancement or the discovery of a new resource input.
One positive supply shock that can have negative consequences for production is money inflation. A large increase in the supply of money creates immediate, real benefits for the individuals or institutions who receive the additional liquidity first; prices have not had time to adjust in the short run. Their benefit, however, comes at the expense of all other members of the economy, whose money loses purchasing power at the same time that fewer goods are available to them. As time moves forward, production becomes less efficient. Real wealth generators are left with fewer resources at their disposal than they otherwise would have had. Real demand drops, causing economic stagnation.
Negative supply shocks have many potential causes. Any increase in input cost expenses can cause the aggregate supply curve to shift to the left, which tends to raise prices and reduce output. A natural disaster, such as a hurricane or earthquake, can temporarily create negative supply shocks. Increases in taxes or labor wages can force output to slow as well since profit margins decline and less efficient producers are forced out of business. War can obviously cause supply shocks. The supply of most consumer goods dropped dramatically during World War II as many resources were tied up in the war effort and many more factories, supply sites and transportation routes were destroyed.
Supply Shock and 1970s Stagflation
The most famous supply shock in modern American history occurred in the oil markets during the 1970s, when the country experienced a period of strong stagflation. The Organization of Arab Petroleum Exporting Countries (OAPEC) placed an oil embargo on several Western nations, including the United States. The nominal supply of oil did not actually change; production processes were unaffected, but the effective supply of oil in the U.S. dropped significantly and prices rose.
In response to the price increase, the federal government placed price controls on oil and gas products. This effort backfired, making it unprofitable for the remaining suppliers to produce oil. The Federal Reserve attempted to stimulate the economy through monetary easing, but real production could not increase while government constraints remained in place.
Here, several negative supply shocks occurred in a short period of time: reduced supply from an embargo, reduced the incentive to produce from price controls and reduced demand for goods resulting from a positive shock in the supply of money.